Working Paper: NBER ID: w16495
Authors: Troy Davig; Eric M. Leeper; Todd B. Walker
Abstract: We use a rational expectations framework to assess the implications of rising debt in an environment with a "fiscal limit." The fiscal limit is defined as the point where the government no longer has the ability to finance higher debt levels by increasing taxes, so either an adjustment to fiscal spending or monetary policy must occur to stabilize debt. We give households a joint probability distribution over the various policy adjustments that may occur, as well as over the timing of when the fiscal limit is hit. One policy option that stabilizes debt is a passive monetary policy, which generates a burst of inflation that devalues the existing nominal debt stock. The probability of this outcome places upward pressure on inflation expectations and poses a substantial challenge to a central bank pursuing an inflation target. The distribution of outcomes for the path of future inflation has a fat right tail, revealing that only a small set of outcomes imply dire inflationary scenarios. Avoiding these scenarios, however, requires the fiscal authority to renege on some share of future promised transfers.
Keywords: Inflation; Fiscal Policy; Debt
JEL Codes: E31; E52; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fiscal stress (H69) | Inflation expectations (E31) |
| Timing of policy adjustments (E61) | Inflationary outcomes (E31) |
| Policy adjustments (E63) | Inflationary outcomes (E31) |
| Rising debt levels (H63) | Policy adjustments (E63) |